DST Systems Q2 2006 Earnings Conference Call Transcript (DST)

DST Systems, Inc. (DST)
Q2 2006 Earnings Conference Call
June 21, 2006 11:00 am ET

Executives

Tom McDonnell - President, CEO, Director
Tom McCullough - COO, EVP, Director
Ken Hager - CFO, VP, Treasurer

Analysts

Charles Murphy - Morgan Stanley
James Kissane - Bear Stearns
Pat Burton - Citigroup
Gregory Smith - Merrill Lynch
Dave Koning - Robert W. Baird
Phil Mickelson - JP Morgan
Bryan Keane - Prudential Equity Group
Robert Lee - KBW
Alan Wake - Castle Creek
Terry O'Connor –

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the DST Systems second quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Mr. Tom McDonnell, President and Chief Executive Officer. Please go ahead, sir.

Tom McDonnell

Thank you and good morning. Before starting today, I would like to make a statement under SEC procedures and rules. If in the course of our conference call today we make forward-looking statements respecting DST and its businesses, such statements would be based on our views as of today, and actual results could differ. There could be a number of factors affecting future results, including those set forth in DSTs latest periodic report, which we file with the SEC. All such factors should be considered in evaluating any forward-looking statements, which we may make today.

Also, all of our comments today on financial results are based on the results excluding certain items set forth in the release under the section: Use of Non-GAAP Financial Information, also known as non-GAAP adjustments. A reconciliation of GAAP financial results is included in the press release.

On that basis, net income of the second quarter of 2006, totaled $51.6 million, that's $0.70 per diluted share. That compares to $52.2 million or $0.65 per diluted share for the second quarter of 2005. That was a decrease of 1% of net income, and an increase of 8% for diluted earnings per share. Just by reference, the earnings per share for the quarter on a GAAP basis were $0.76.

Consolidated operating revenues increased by $27.1 million, or 7.5% over the second quarter of 2005. For comparative purposes, the 2005 second quarter revenues exclude EquiServ, lock\line, and DST Innovis.

Financial services revenues increased from additional mutual fund share owner account growth, increased DST International Professional Services revenues, and higher Health Solutions revenues, resulting in the inclusion of a full quarter of Heath Solutions revenues in '06 versus two months in '05. This business was acquired at April 29, 2005.

Output Solutions revenues increased by $13.6 million or 11.4%. That reflected higher processing volumes, increased international revenues from new customer relationships in Canada and the UK, and increased revenues from the billings for paper stock, which had been previously directly provided by the clients, or by some clients which we now acquire and re-bill to them. Although items mailed increased by 26.6% to 648 million pieces, lower per unit pricing and certain large daily cycle billing clients tended to offset the volume increase.

Consolidated income from operations in the second quarter 2006 decreased by $16.5 million or 19.1% to $69.8 million. On a comparative basis, there was improved performance in the financial services segment, resulting in lower operating cost and increased contributions from mutual fund share owner processing, and from DST International. Lower contributions from the Output Solutions segment, and the absence of contributions from EquiServ, DST Innovis, and lock\line, which were sold, more than offset the positive financial services performance.

Consolidated operating margin for the quarter was 18.3% compared to 18.4% for the prior year quarter. Financial services income from ops increased by $3.1 million or 4.9% over the second quarter of 2005 to a level of $66.4 million. That was from higher mutual fund revenues and certain cost improvements. However, Output Solutions Income from operations declined by $5.8 million, so that was almost a 90% decrease to $700,000. That reflects the lower unit pricing for certain clients, increased cost to support the higher volumes, and the continuing expenditures for implementation of new printing and inserting technologies.

The equities and earnings of unconsolidated affiliates increased by $9.5 million from the 2005 second quarter to a level of $18.3 million, that's principally from the inclusion of equity and earnings of Asurion, and higher earnings from BFDS and Argus, with a modest offset by lower earnings from IFDS.

Higher earnings from BFDS were the result of increased accounts serviced and improvement in operations. The earnings decrease at IFDS was related to a deferred tax benefit that had been recorded in 2005. Earnings in Argus increased from both new client conversions and increased volume by processing of Medicare D claims.

Effective income tax rate for the 2006 second quarter was 34.2% that compared to 37.9% for the second quarter of '05. Currently, we are expecting our effective tax rate for the remainder of 2006 to be 34.9% that would exclude the effect of any discrete period items.

During the quarter, DST repurchased 364,200 shares of our common stock at an aggregate cost of $21.9 million. There are approximately 2.4 million shares remaining under the existing share repurchased authorization. DST had 67.1 million shares outstanding at June 30, 2006, excluding 2.4 million share of unvested restricted stock. The effect of share repurchases and shares issued from stock option exercises resulted in a net decrease of total shares outstanding of 100,000 shares for the quarter, and 2.2 million shares on a year-to-date basis.

The dilutive effect of the convertible debentures was 2.9 million shares. The dilutive effect of outstanding stock options was 1.9 million shares. Restricted stock was 1.1 million shares. Those totaled to 5.9 million shares of dilution. Average diluted share outstanding for the second quarter of 2006 were 73.2 million shares, that's a decrease of 200,000 shares from the first quarter of '06.

An update on the total stock option and restricted stock that are currently outstanding at June 30, 2006 – there are 12 million shares outstanding, and that is a decrease of 500,000 shares, or 4% from the March 31, 2006 quarter.

US Mutual Fund share owner accounts processed - turning to that - totaled $104.1 million at June 30, 2006, that was a net increase of 600,000, or six-tenths of a percent from the 103.5 million accounts serviced at March 31, 2006 and an increase of 1.9 million or 1.9% from December 31.

Inside of that, tax advantage, retirement, and educational savings accounts serviced totaled 40 million accounts at June 30, 2006. DST received no new mutual fund client commitments during the quarter.

As previously reported on July 13, 2006, DST received a $254 million cash dividend from Asurion. That payment was part of a debt finance distribution made by Asurion to all of its shareholders. Asurion also made dividend equivalent bonus payments to stock option holders, and the compensation expense allocatable to DST’s interest in Asurion is estimated to reduce DST’s net income by approximately $8 million in the third quarter of 2006. More properly, reduced by $8 million our share of Asurion's net income in that period.

Under the equity method of accounting, the dividend will not be treated as income, but the carrying value of DST’s investment of Asurion will be reduced by the amount of the dividend received. Interest cost associated with the debt incurred by Asurion, the fianance distribution is expected to negatively impact DSTs equity and earnings of Asurion in the foreseeable future.

The combined amortization of intangibles affecting DST’s equity in the earnings of Asurion during the quarter was $1.7 million. For the six months ended June 30, 2006, that figure was $3.1 million. DST also recorded intangible amortization from the acquisition of DST Health Solutions of approximately $1.5 million for the quarter, and $3 million for the six months ended June 30, 2006.

With that we would now like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Charles Murphy from Morgan Stanley. Please go ahead.

Charles Murphy - Morgan Stanley

Thanks. Hi Tom. I had a question on the Delaware investment contract transition announced this quarter, just wanted to see how much that could affect revenue and operating income in '06 and '07. Will it be a net increase in operating profit? Approximately how much? Then what percent of US accounts do you see moving to that type of relationship over the next year or two?

Tom McDonnell

Charles, the question runs to the Delaware decision to migrate their processing to our organization on a full service basis where they were previously a remote client. For the very fact that will increase operating revenues, of course, on a unitized basis, and therefore, on an absolute basis. We have speculated in the past that there are more clients looking at whether or not they should continue to retain the breath of full service operations as they do for themselves.

There continues to be investigation of a number of clients of that possibility. We have actually no way to quantify what the percent or amount of movement will actually occur. Those are client by client decisions, but we do think there is certainly a level of activity there. If clients do move from a remote status to full service, either with DST or Boston Financial, we see that as generally positive.

Charles Murphy - Morgan Stanley

Okay, great. Will that relationship be a net positive to absolute operating profit?

Tom McCullough

Yes. This is Tom McCullough. It will be a net positive.

Charles Murphy - Morgan Stanley

Okay, great. Thanks very much.

Operator

Thank you. Our next question comes from the line of James Kissane from Bear Stearns. Please go ahead.

James Kissane - Bear Stearns

Thanks. Tom, the margins in the financial segment were very strong, especially given that the software revenue was down year to year. Can you talk about some of the factors, or elaborate on the factors driving the strong margins there?

Tom McDonnell

We've felt, Jim, for some time that we should see margins recovering in our estimation. They are probably strong on a quarter-to-quarter basis, but we have believed that we could sustain better margins there. I think the organization has done a good job on the cost side. Also, even though the revenue growth hasn't been dramatic, revenue growth from base where we were is very - it does have positive attributes when it does flow through.

We're not doing anything different than we would normally do, and that's stay on top of the cost side. Hopefully we can continue to grow some of the revenue side. I should mention though, as we often do this time of year, third quarter is when we tend to bring in additional equipment resources, particularly in the data center to be in good shape to handle any year-end activity. We wouldn't have a huge impact in that quarter, but that is when we do ramp up for year-end, so you might want to keep that in mind.

James Kissane - Bear Stearns

I know you talk about the pipeline anymore, but can you say whether or not you did not win business that was awarded in the quarter?

Tom McDonnell

We did say that we didn't win any business in the quarter. Was there any other business awarded in the quarter? Not that we're aware of.

James Kissane - Bear Stearns

Okay, good. So you didn't lose any share. The plans for the $254 million cash dividend from Asurion, because your buyback program is pretty small. Will you be expanding the buyback? Is that the primary use of the proceeds?

Tom McDonnell

We really haven't determined those proceeds yet. We're carrying some interim debt on the balance sheet. That would be the short-term utilization for it. That's a flexible line, but I think we'll just take a look at what the best opportunities are for it over the next several months, but we are committed and continue our buyback. The quarter was a little light in that because of some of the other things like the dividend that we're going on. The opportunity was not always available to us to be in the market.

James Kissane - Bear Stearns

The authorization is pretty small at this point now too.

Tom McDonnell

Its 2.4 million remaining, which is something we will revisit, but it does give us some flexibility for the moment.

James Kissane - Bear Stearns

Could I ask the thinking behind Asurion dividends? Was that a DST decision, an Asurion decision? My understanding is that you are the biggest shareholder of Asurion.

Tom McDonnell

It's clearly an Asurion decision and the Company and that organization felt that given the success of their business so far, it was an appropriate action on their particularly. Beyond that we really can't comment on Asurion activities.

James Kissane - Bear Stearns

Thanks, Tom.

Operator

Thank you, and our next question comes from the line of Pat Burton from Citigroup. Please go ahead.

Pat Burton - Citigroup

Hi, congratulations on the quarter and the Asurion transaction. My question relates to some of then numbers that have now popped out from the Asurion transaction. Is the $8 million number a one-off expense?

Tom McDonnell

Yes, it is.

Pat Burton - Citigroup

So that's just compensation to the management or something that was triggered by the dividend?

Tom McDonnell

The Company chose to treat, because of the nature of a private company, option holders similar to stockholders, and made bonus distributions to compensate for the distribution that would have been made if they held the stock directly.

Pat Burton - Citigroup

Okay, and on an ongoing basis obviously, we should estimate what the interest expenses they'll be incurring from the recap and take that out of Asurion net income. Therefore, DSTs share of it, is that correct?

Tom McDonnell

That's what we attempted to - you explained that quite well. That's correct.

Pat Burton - Citigroup

Thank you on that, and it looks like a great transaction for you guys to raise a bunch of cash. Last question I'll leave you with, on the software sales, Tom, you told us for awhile that number could be lumpy. Was that just one of the quarters where it just turned down year-on-year?

Tom McDonnell

Yes, software sales do tend to be lumpy. One of the things that we do stress is that, again if we had any luxuries it may be one we have in the software sales side. A lot of companies that sell a lot of software, there is a lot of pressure around quarter-end, and so forth, to cut deals. You see a lot of pricing softness.

Our general approaches is if software sales are going to be solid, really timing is less of a concern to us than the stability of the pricing in that area, so we probably don't see as many rushes to close around the quarter-end.

This time of the year things get a little slow anyway. I think there is some legitimate software prospects out there both in the DST International arena, AWD and Health Solutions, but I think there is probably a little back ending, if not into the third quarter, maybe even into the fourth.

Pat Burton - Citigroup

Thank you.

Operator

Thank you. Our next question comes from the line of Gregory Smith from Merrill Lynch. Please go ahead.

Gregory Smith - Merrill Lynch

Is there any way to give us the amount of debt or the change in debt for Asurion, just so we can better model this incremental negative impact on the earnings going forward?

Tom McDonnell

That is not a number we can publicly release.

Gregory Smith - Merrill Lynch

Is there anything you can give us to help us better model what's going to happen to the earnings at Asurion?

Tom McDonnell

Not really. I apologize for that, but they are a private company and we have to respect that position.

Gregory Smith - Merrill Lynch

The results at Argus popped up nicely. Do you view that as a sustainable change in their profit outlook?

Tom McDonnell

I think we're reasonably optimistic that Argus has stepped up to a different level, or a different plateau of earnings. They were able to sign some significant clients' end of last year, so the absolute number of insured lives that they processed for has increased. Some of the new clients and existing clients have aggressively entered the Medicare Part D arena, which drives a very, very high volume of prescriptions per insured live. So that's been very positive for them.

However, the earnings increase that you see there, if you look through it, it is produced by a very, very significant overall change in the volumes they're processing. They've had to make significant staff additions, and there is an ongoing investment to support this new level. Having said that, I think they have stepped up to probably a different order of magnitude and we would expect it to be sustainable.

Gregory Smith - Merrill Lynch

Okay, great. Then lastly, can you give us any indication on the tax rate as of '07?

Tom McDonnell

'07? I'll let Ken deal with that. We've referenced the rate here. The high rate in the quarter last year was related to a one time transaction, but I'll let Ken comment on going forward.

Ken Hager

Greg, it would be a little premature at present to give you any kind of real good guidance on that. I'm sorry, but I would imagine that the rate would be up a little bit over what we expect to the return rate to be in '06, about 34.9.

Tom McDonnell

That's helpful. Thanks a lot guys.

Operator

Thank you, and our next question comes from the line of Dave Koning from Robert W. Baird. Please go ahead.

Dave Koning - Robert W. Baird

Hi guys. I wanted to pursue Output just a bit. You're having tremendous momentum in the number of images produced mid-thirties type growth. Though revenue has been more around the double-digit range this quarter, and I know you talked a little bit about per unit pricing. If it declines in price of say 15% or so per image, is that the way to think about this going forward? If so, if we see a deceleration in images, could this segment go into a stable revenue mode?

Tom McDonnell

Obviously, we did see stabilization of images. We have been doing quite a bit of work with Output. We recognize that's not exactly evident by the results of this quarter. We have seen in the Output areas an extremely competitive business. There has been a lot of price pressure in the very large client bases. In order to react to that, we introduced and in some cases proprietary and patentable technology of our own to change what we believe to be the cost equation on a going forward basis.

It's not an inconsequential investment. That's part of what you're seeing which we referenced in here. That investment, new equipment coming in, and as we mentioned we doubled the climate for books as well as tax, so you would have a front end impact of those types of investments. We believe we're making the right investments. Like all new technologies, it takes a little time to burn it in and to get it adjusted. We believe we have an approach that not only will adjust the cost side of the equation going forward, but will get us a product that's not only competitive price wise, but will have significant other advantages to the clients. If we're successful in that we think that going forward we'll start to see Output's results come around.

I think from where we are we don't see tremendous price erosion going forward. With the current client base there does in the various different areas, whether it's wireless, telecom, mutual funds, or whatever, there is at least some level of internal growth in most of those. So, I'm not sure we would see a decline in images. Hopefully, maybe all three of the aspects, the price pressure, the relative volumes, and the cost incurred to get the technology in place are all coming to the low points on one side and the high point on the other. We're looking for progress from here.

Dave Koning - Robert W. Baird

Just as a follow up, I'm wondering if you could quantify the paper stock revenue benefit, if that contributed a few percent to the 11% growth. Secondly, what the margin impact of the accelerated depreciation is, and when that goes away?

Tom McDonnell

We won't be able to break out the accelerated depreciation margin because that would take quite a bit of work. Not that we wouldn't be able to do it, but basically as equipment comes in over different periods you are layering new depreciation curves on top of the existing ones. So that would not yet have stabilized. I would say without being able to specifically quantify it, I would expect the next two to three quarters to continue to see equipment adds, therefore, at least no decrease in the depreciation expense, and maybe a slight upward bias.

Ken may have a ballpark on the amount of revenue that has shifted from client-supplied paper to client-billed paper.

Ken Hager

That's probably a couple percent of the - 2% to 3% of the increase.

Dave Koning - Robert W. Baird

Thank you. Just one final question, I don't know if you're willing to quantify this at all, but the client that's leaving, is that a 5% of revenue type client for Output? Is there any metrics you can give on that?

Tom McDonnell

We haven't disclosed any metrics on that. I'm not sure that they would be relevant at this point, because it's a client that will move in segments and not all at one piece. Then again, I just don't have it in front of me.

Dave Koning - Robert W. Baird

Okay, great. Thanks a lot for the help.

Operator

Thank you. Our next question comes from the line of Phil Mickelson from JP Morgan. Please go ahead.

Phil Mickelson - JP Morgan

Yes, I was wondering if you could give us some color around the health processing business. Where you stand? I know there were some personnel additions within that space, so I'm trying to understand a bit of the growth initiatives. If you need to build scale, invest in that business, maybe acquisitions for strategic?

Tom McDonnell

The business is, as you know, a health claims processing business. It operates in three modes, software licensing, remote support or ASB processing for clients, and then third-party administration or full service processing. The company is positioned well in all of those and some of the additions you saw; we're expanding the sales force organization. As we've indicated before, part of the long term opportunity there is integration of our AWD product with some of the Health Solutions products. It's integrated with two of their products now, and those AWD-enhanced products are now able to be rolled out in those two segments to existing client base, and presented to new clients.

We also believe that there are attractive opportunities to integrate our Output capabilities to the front to back end processing for the health care side. We're moving forward to get the integration or our technology, get the sales force expanded to where we think it's appropriate to cover this market, and start to cross sell products, in particularly, our Output processing. We've been working on all that for the last year. We have a lot of that done. We are now in a much better position facing off to the market. We have enhanced the sales capability, so from here we have the product set and the identification of BFDS technologies that will enhance that opportunity. The challenge now is to get it out and get it sold.

Phil Mickelson - JP Morgan

With the hires that you've had in the quarter, what's the magnitude of the sales force expansion? How many sales people are you talking about approximately selling this product?

Tom McDonnell

About six - when we say expansion, when we acquired the company from CSC, basically it really did not have an organic sales force. It relied to CSC on that, so this is one we have had to build from the bottom up.

Phil Mickelson - JP Morgan

As far as data center capacity, all that's in place? You don't need to expand footprint? You have enough facilities in place to…?

Tom McDonnell

When you talk about the physical structure of the data center footprint, that's in place, but as I mentioned earlier, we always look to capacity expansions around the third quarter of the year. When we anticipate year-end volumes in the financial services area, we want to be prepared for those. As we have our normal expansion, the capacity we usually have, opted to bring those in more into the third quarter, early fourth quarter just to ensure that capacity is there for any unforeseen volume shifts that might occur that December through March period.

Phil Mickelson - JP Morgan

One last thing, is there any kind of seasonality in the software sales within this business, or is it just too small yet, so that's not really a relative factor at this point?

Tom McDonnell

When you say within this business? Are you talking about the Health Solutions?

Phil Mickelson - JP Morgan

Health Solutions, correct.

Tom McDonnell

I don't believe there is any particularly seasonality anymore than any other product. Having said that I think there is always from the client's side, there is always their budgeting process. You tend to see more active interest in acquiring software in the first, second and fourth quarter, but it's not a predictable seasonality.

Phil Mickelson - JP Morgan

Thank you very much.

Operator

Thank you. Our next question comes from the line of Bryan Keane from Prudential. Please go ahead.

Bryan Keane - Prudential

Good morning. Could you just remind us what the breakout is between accounts, between remote and full service? Then, is it still about $3 to $4 per account for remote, and three to four times that for full service?

Tom McDonnell

Tom McCullough can answer that for you.

Tom McCullough

The breakout on accounts is about 70% as remote and 30% full service.

Tom McDonnell

When you say 30% full service that includes BFDS book?

Tom McCullough

That would include the BFDS book. The per account charges are very difficult to come up with common numbers, because there is a lot of variance depending on the services that they are offered.

Tom McDonnell

But orders of magnitude and relative you are generally in the ballpark.

Bryan Keane - Prudential

Just on the pipeline of accounts, I know you don't quantify that anymore, but can you at least give us some idea if it's active or is there a lull period to be expected here over the next couple of months?

Tom McDonnell

Again, we just decided not to comment on it at all, because every time we get into the discussion of it, we can't predict when clients are making decisions. We don't want to appear difficult. We will just report clients who signed.

Bryan Keane - Prudential

All right, I just though I'd give it a shot. Thank you.

Tom McDonnell

Good try.

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Robert Lee from KBW. Please go ahead.

Robert Lee - KBW

Good morning. I have a question - organic growth in the mutual fund business has been fairly lackluster for awhile, and I know you have developed some products for the Omnibus market, as well the S&A market. Have you seen any traction with those? Could you bring us up to speed on where those businesses stand, or where those product initiatives stand?

Tom McCullough

On the Omnibus side, 22C2, which is suppose to take effect in October, there are still a lot of question marks as far as what's going to happen. We do have a very viable product that there is a lot of interest in, but people are still playing a wait and see game. Then on the separately managed account arena, it is an area that is growing. It is an area that we continue to look at and work with our customers on.

Robert Lee - KBW

Have you been able to win much business there, or is that still in the building phase?

Tom McCullough

We have two customers today that are using one of our products. We think that's going to be a good building block for us.

Robert Lee - KBW

Thank you.

Operator

Thank you. Our next question comes from the line of Alan Wake from Castle Creek. Please go ahead.

Alan Wake - Castle Creek

Good morning. Thank you. I want to talk to you a little bit about some of the M&A activity in the space and see whether you guys are really better buyers or sellers. Certainly, even companies that are loosely in your space like CSC explored doing an LBO. Just wanted to see if you guys have looked at exploring either LBO or anything else in the M&A activity.

Tom McDonnell

Even if we had, we wouldn't comment on it. There is no way for us to comment on activities that we may be considering. In any business you always see companies that are looking for a buyer that are presented to us. If they are interesting, we look at them, if they're not we don't. I think that's not unusual for companies, but we certainly do not comment publicly or make any disclosures on that until we have something in place that requires a disclosure and it becomes appropriate.

Alan Wake - Castle Creek

You are, then, potentially, actively looking to expand your business by purchasing other companies if they were to come at the right price?

Tom McDonnell

I don't think we said that. I said I think we look at things when they are presented to us.

Alan Wake - Castle Creek

Okay.

Operator

Thank you. One moment please for our question. Our next question comes from the line of Terry O'Connor. Please go ahead.

Terry O'Connor -

I want to explore the sales effort at Health Solution business a little bit more. I was intrigued by your comment. You said that, "CSC had no dedicated sales on this product."

Tom McDonnell

I didn't say that they didn't have people working on the product; I said they were at the CSC level and the sales force did not transition over with the health service acquisition.

Terry O'Connor -

Okay, so it's not an orphan.

Tom McDonnell

No, I wouldn't think so, but the point was we didn't pick out the sales capability because it was integrated with the CSC sales strategy of selling a broader range of products, so we had to really basically build a Health Solutions specific sales organization.

Terry O'Connor -

Is there any reaction in the market place when you have a more focused sales force on this? Have you seen any new vibrancy in the sales effort? That's number one, or does the sales effort have to wait for the AWD product to get integrated in to really kick things off? Lastly, on the salesmen that you have in place, the six people, are they experienced in this area, or are they people you have to train?

Tom McDonnell

Obviously, whenever people come into a specific product set there is some familiarity with that, but the organization has been built from either directly from health related businesses or other closely aligned technologies. It's an experienced organization from that sense. We really just had that assembled as based on those announcements. We had the product offerings out. We are now able to talk about some of the integrated AWD product. We feel optimistic as do the sales force, but it's pretty early to determine whether or not that internal optimism will transfer effectively to the sales effort.

Terry O'Connor -

Thank you.

Operator

I'm showing that we have no further questions at this time, sir. Please continue.

Tom McDonnell

If we have no further questions, then we appreciate everybody calling in. We look forward to speaking with you at the end of the next quarter. Thank you.

Operator

Thank you. (Operator Instructions) That does conclude our conference for today. Thank you for your participation.

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